It is generally believed that most people know what their home equity is. However, many people are still confused about this topic. As a homeowner, you need to understand how home equity works. This is especially true if you are looking to refinance a mortgage or loan for your residence.
It is generally believed that most people know what their home equity is. However, many people are still confused about this topic. As a homeowner, you need to understand how home equity works. This is especially true if you are looking to refinance a mortgage or loan for your residence.
Key takeaways
- Home equity is the value of your ownership stake in your home, calculated by subtracting your outstanding mortgage loan from the market value of the property.
- Few lenders will let you borrow your entire estate.
- Under normal economic conditions, you might be able to borrow 80% to 90% of your available equity.
- During the coronavirus pandemic, lenders have limited access to home equity and increased credit scoring requirements, particularly for home equity lines of credit (HELOCs).
How much home equity do you have?
Your home equity is the difference between your home’s current market value and your total debt (primarily your primary mortgage).
As a borrower, with a home equity loan, the amount of credit you can get depends on how much equity you own. Say your house is worth $250,000 and you owe your mortgage $150,000. Just subtract your remaining mortgage from the value of the house, and you’ll have $100,000 in home equity.
How Much Home Equity Loan Can You Get?
Few lenders will let you borrow your entire property. They usually allow you to borrow up to 80% to 90% of your available equity, depending on your lender, credit, and income. So, if you have $100,000 in home equity, like the example above, you can get an $80,000 to $90,000 home equity line of credit (HELOC). Race, nationality, and other non-financial factors shouldn’t play a role in determining how much home equity you can borrow.
Mortgage discrimination is illegal.
Below is a second example that takes into account more factors. Say you have a 30-year mortgage on your house for 5 years. Also, a recent appraisal shows that your home has a market value of $250,000, leaving $195,000 left on the original $200,000 loan. Remember, nearly all early home mortgage payments go toward down payment interest.
If the house has no other debt, you have $55,000 in home equity. This equals the current market value of $250,000 minus the debt of $195,000. You can also divide your home equity by market value to determine your home equity percentage. In this case, the home equity percentage is 22% ($55,000) ÷ $250,000 = .22).
Now, let’s say you take out a $40,000 home equity loan in addition to your mortgage. The total liability on the property is $235,000 instead of $195,000, which would bring your total equity to $15,000, bringing your home equity ratio down to 6%.
Transaction cost
Real estate is one of the most illiquid assets, so there is usually a cost associated with going into your home equity. If you do sell the house, the total closing cost is usually between 2% and 5% in the US. Buyers typically pay many of these fees but are aware that they may use these fees as an excuse to negotiate a lower sales price.
If you take out a home equity loan, you may have to pay some type of loan origination fee. Second mortgages and home equity lines of credit (HELOCs) also typically have higher interest rates than original mortgages. After accounting for these transaction costs, the amount of home equity you can use is less than what you theoretically own.
Loan-to-value ratio
Another way to express home equity is through the loan-to-value ratio (LTV ratio). Calculated by dividing the remaining loan balance by the current market value. Using the second example above, your loan-to-value ratio is 78% (yes, that’s the flip side of your home equity percentage (22%)) and it climbs to 94% as you put in a $40,000 home equity loan.
Potential lenders use the loan-to-value ratio to decide whether to approve your additional loan application.
Lenders don’t like high loan-to-value ratios because it indicates that you may have too much leverage and may not be able to repay your loan. In times of economic turmoil, they can tighten lending standards. That happened during the global coronavirus crisis. For home equity lines of credit (HELOCs) in particular, banks have increased their credit score requirements from 600 to 700. They also lowered the dollar amount and the percentage of home equity that is willing to take out a loan.
When the market value of home changes, both the loan-to-value ratio and home equity fluctuate. During the subprime mortgage crisis of 2007-2008, millions of dollars in home equity were wiped, and home prices didn’t always rise. The long-term impact of the coronavirus crisis on home equity remains uncertain.
